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Chapter 11
Aggregate Demand
and Supply
Learning Objectives
• Explain how the aggregate demand
curve differs from the individual demand
curve.
• List and explain two reasons why the
aggregate demand curve slopes down.
• Define the aggregate supply curve.
• Explain why the aggregate supply curve
slopes up.
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11-2
Economic Models
• Business fluctuations—recessions and
expansions—are an important aspect of
macroeconomics. Indeed, much of
macroeconomics is concerned with how
to predict and prevent recessions. In
order to make such predictions,
economists and government policy
makers have to use a model of the
macroeconomy.
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11-3
Economic Models (cont.)
• In this chapter we examine two models:
– The simplest model of the circular flow of
income and product within our economy.
– The aggregate demand and aggregate
supply model.
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11-4
The Two Principles of the Circular
Flow of Income
• The concept of a circular flow of
income (ignoring taxes) involves two
principles:
1. In every economic exchange, the seller
receives exactly the same amount that the
buyer spends.
2. Goods and services flow in one direction
and money payments flow in the other.
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11-5
Figure 11-1: The Circular Flow of
Income and Product
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Distinguishing Between Product
and Factor Markets
• Product Markets: Transactions in
which households buy goods take place
in the product markets—that’s where
households are the buyers and
businesses are the sellers of consumer
goods.
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11-7
Distinguishing Between Product
and Factor Markets (cont.)
• Factor Markets: In these markets,
households are the sellers of resources
such as labor, land, capital, and
entrepreneurial ability.
• Businesses are the buyers in factor
markets; business expenditures
constitute income for households.
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11-8
Expanding the Circular Flow
Model
• We can think of the top part of the
circular flow model with government and
the foreign sector added as a
representation of gross domestic
product, or GDP.
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11-9
Expanding the Circular Flow
Model (cont.)
• The Government Sector: Its
participation involves government
spending on goods and services,
government spending on wages and
salaries for its workers and payments to
welfare recipients and farm owners,
plus many other types of outlays.
• The government also collects revenues
from taxes.
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11-10
Expanding the Circular Flow
Model (cont.)
• The Foreign Sector: Americans
purchase goods and services from
foreigners, called imports. Foreigners
purchase goods and services from us,
called exports.
• When we purchase more from
foreigners than they do from us, we
have to talk in terms of negative net
exports.
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11-11
Putting It All Together
• You now have all of the elements of
gross domestic product, or
GDP = C + I + G + X.
• In this formula,
– C equals consumer spending;
– I equals mainly business spending on
investment (capital goods);
– G is government spending; and
– X is net exports.
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11-12
Aggregate Demand
• Aggregate demand is the total dollar
value of all planned expenditures in the
economy.
• It consist of spending by consumers on
goods and services, spending by
businesses on investment, spending by
the government, and net exports.
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11-13
The Aggregate Demand Curve
• When talking about aggregate demand,
we examine the relationship between
aggregate quantity demanded and the
overall price level.
• The aggregate demand curve gives
the total amount of output that will be
purchased at each price level.
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11-14
Figure 11-2: The Aggregate Demand
Curve
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What Happens When the Price
Level Rises?
• If the average price of goods and services
rises, then consumers will be buying fewer of
these goods and services. Hence, the
aggregate demand curve is downward
sloping.
• There are economy-wide factors that explain
why the aggregate demand curve slopes
downward. Two of them are: the real-balance
effect, and the open economy effect.
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11-16
The Real-Balance Effect
• If the price level goes up while you hold
cash, the real value of that cash goes
down, just as if a pickpocket stole some
cash out of your wallet.
• Hence, you buy fewer goods and
services.
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11-17
The Open Economy Effect
• Given any set of exchange rates between the
U.S. dollar and other currencies, an increase
in the price level in the United States makes
U.S. goods more expensive for foreigners.
• Relatively cheaper prices for foreign goods
cause U.S. residents to want to buy more
foreign goods, and lowers their demand for
domestically produced goods and services.
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11-18
Shifts in the Aggregate Demand
Curve
• Any change in a variable that increases
the amount of output people want to buy
at a given price level is said to cause an
increase in aggregate demand.
• Graphically this is known as a shift to
the right of the aggregate demand
curve.
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11-19
Table 11-1: Determinants of
Aggregate Demand
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11-20
Aggregate Supply
• Aggregate supply is the total of all
planned production for the entire
economy, usually over a year period.
• In the short run, the overall price level is
related to the output of final goods and
services in the economy.
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11-21
Aggregate Supply (cont.)
• If the price level goes up and wages do
not, overall profits will rise.
• Producers will want to supply more to
the marketplace—they offer more
output as the price level increases.
• This positive relationship is called
aggregate supply.
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11-22
Figure 11-3: The Aggregate Supply
Curve in the Short Run
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11-23
Table 11-2: Determinants of
Aggregate Supply
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11-24
Putting Aggregate Demand and
Aggregate Supply Together
• When we combine the aggregate
demand curve with the aggregate
supply curve, we find equilibrium at
their intersection.
• In equilibrium, when the aggregate
quantity demanded equals aggregate
quantity supplied, the equilibrium price
level is determined as well as the
equilibrium level of real GDP per year.
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11-25
Figure 11-4: Equilibrium Price Level
and Output
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11-26
Looking at the National Economy
Using the AD-AS Model
• Changes in Federal Taxes: In general,
a decrease in taxes will cause the
aggregate demand curve to shift
outward to the right.
• Consider the Bush tax cuts that started
to go into effect in the early 2000s, as
seen in Figure 11-5, next.
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11-27
Figure 11-5: Effects of the Bush
Tax Cuts
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Looking at the National Economy
Using the AD-AS Model (cont.)
• Immigration: Increased immigration
over time leads to a larger supply of
labor. While there are many who believe
that immigration hurts America, at least
in the short run and certainly in the long
run immigration causes the aggregate
supply curve to increase—shift outward
to the right.
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Key Terms and Concepts
• aggregate demand
• aggregate demand
curve
• circular flow of
income
• exports
• aggregate supply
• imports
• aggregate supply
curve
• net exports
• cash balance
• open economy
effect
• real-balance effect
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